OCBC OneWealth App– Turbulence as we transition

4 September 2018

While the economic backdrop appears sound, the geo-political environment is less stable. Headlines have been dominated by protectionist rhetoric, major territorial disputes, terrorism, surging cyber-crime and even the threat of a nuclear war.
As can be gleaned from the chart below, the gauge for economic policy uncertainly has trended higher over the past few months.
Geopolitical risks have risen as well, with reports of conflicts in the Middle East increasingly making headlines.
In Europe, rising populism is a source of worry. In 2000, populist parties captured 8.5% of the national votes on average. This has risen to 24.1% in 2017.

Financial markets are also facing added pressure from central banks, which are mostly seeking to normalize interest rates from historic lows and, where possible, remove easy money by trimming their balance sheet.
A Federal Reserve doggedly focused on tightening monetary policy and a US administration determined to put “America First” whatever the cost, are ingredients for a potentially nasty cocktail.

Yet, in spite of the hubbub of geo-political and policy-related risks, market volatility has remained relatively low, with Wall Street’s fear gauge – the VIX index – trading below the five-year average.
The relative quiet in the market betrays a sense of complacency about these risks.

Unfortunately, headline risks have not fully subsided and we do not expect them to anytime soon.
The Western world and the Middle East continue to reel from the Trump administration’s often abrasive posture to foreign policy.
In addition, the tug of war between political orthodoxy and populist sentiments looks poised to continue as both Europe and the US face an election year.
Meanwhile, Italian risk continues to lurk in the background given the new populist coalition government’s intent to reverse austerity and pursue an expansionary fiscal agenda, bringing the country in direct conflict with the European Union and its unwavering focus on fiscal discipline.

At the same time, central banks will be looking for reasons to hike interest rates and trim balance sheets in the face of sustained and improving economic conditions. The Fed is way ahead of the pack where policy tightening is concerned, while the Bank of England and European Central Bank are catching up, though they are still some distance behind.
Monetary tightening in the US would inevitably impact emerging markets in the form of a strengthening greenback and reveal vulnerabilities in the region.
As it stands, mismanaged economies with huge foreign debts like Turkey and Argentina have been on the receiving end of the market’s wrath as sell-off pressure threatens to wreck their currency and bond markets.
On the flipside, Asian economies remember the experience of 1997–98 financial crisis and is nowhere near as vulnerable as it was then, having shored up its current and fiscal accounts. As such, risks are not entirely broad-based, but country-specific.

Ultimately, the process of transitioning to a new - albeit unsettling - political environment and the adjustment to a tighter monetary policy regiment would inevitably engender higher volatility ahead - it’s rarely a smooth process. Investors beware.